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Subprime Sovereign Europe Still the Focus

By: Michael Ashton | Tuesday, February 21, 2012

Like everyone else, I want to believe that the Greek bailout this time really
is 'done.' Of course, my main reason for wanting that outcome is that I am
weary of writing about all of the deals, which turn out not to be deals, which
get trumpeted as deals again, and so on.

Over the weekend, we were assured that there was finally a solution
to the Greek crisis. The ECB (and it turns out today, other European central
banks) will swap their bonds for new Greek bonds that will not be subject to
haircuts. Meanwhile, private bondholders will take a haircut and get new bonds
worth a lot less, although this afternoon the head of the IIF (the group responsible
for the PSI negotiations) told the BBC that this will only work if CDS owners
don't choose to trigger their payouts. So, as long as private-sector bondholders
choose to take less money, this is all good. The IMF is also reportedly contributing
less to the deal than had previously been expected. And all of this is subject
to approval by a number of legislatures.

So the problems of subprime sovereign Europe have not yet been put wholly
to rest. The markets seem unsure on this point. Stocks ended essentially unchanged
after hitting new highs in the morning, on continued low volume. Bond yields
rose, with the 10-year nominal bond up 5bps to yield 2.06% and 10-year TIPS
2bps higher to yield -0.24%. That would seem to indicate some marginal lessening
of tensions, but with volumes thin and equities near-unchanged I think such
a read would be premature. The VIX was higher on the day, although it remains
lower than it was last week.

Commodities had a banner day, relative to equities, with the DJ-UBS index
+1.35%. Precious Metals led the way with a 2.75% gain and Industrial Metals
rose 1.6%. Energy, however, will get the headlines. Although Nat Gas blunted
the performance of the group, NYMEX Crude rose to $105.50, the highest level
since May and 40% above the October lows; Brent reached $121. Gasoline jumped
a nickel to $3.0661/gallon, the highest since driving season and the highest
print ever for the March 2012 contract.

This seems like the first time in a while that commodities have simply smoked
equities, but since the beginning of the year they have kept pace...if you
leave out Nat Gas. Our preferred ETF, USCI, is up 8.98% year-to-date compared
with 8.32% for the S&P. The correlation has been far too high for our tastes,
suggesting that both markets are trading QE3 rather than inflation expectations.
But they too are higher: the INFL Deutsche-issued ETN is +5.0% year-to-date.

While all markets move in lock-step, it is hard for me to believe that the
earthquake has happened. Whether it's the earthquake of Greece failing and
banks coming clean about their losses therefrom (and a potential unzipping
of other subprime sovereigns), or it's the earthquake of Greece getting bailed
out successfully and causing the line of sovereign supplicants to extend
around the block, there's some kind of resolution coming that should fracture,
at least for a while, these high correlations. I believe that in such a circumstance,
commodity indices are the best-valued and most likely to come on top...but
we will see.

However, Bloomberg
claims that the S&P is the cheapest relative to bonds it has ever
been, since 1962. I enjoy the presumably-unintended bias in construction.
Why not say, "Bonds are the most-expensive, relative to stocks, that they
have been since 1962?" Both would be true, if the metric they're pushing
(the spread of the 'earnings yield' to the 10-year Treasury rate) is the
right metric, but one headline implies that stocks are cheap on an absolute
basis while the other headline doesn't imply that. Our equity culture is
alive and well, sadly; but there are many more arguments to be made that
both bond and stock prices are too high than there are to be made
that both are too low. And of course, as I've pointed out before,
saying that stocks are cheap relative to something else is not the
same as saying they are cheap, in the sense they will have better-than-average
returns. By the same token, TIPS are extremely cheap relative to nominal
bonds, but I would not suggest owning them outright at a -0.25% real
yield. So if you want to buy stocks and sell bonds, or you want to buy TIPS
and sell bonds, you may have a winning trade...if you weight the trade right.
Be assured that the correct weight is not equal notional amounts.
That is, if you sell your short-term bond portfolio to buy an equity portfolio
dollar-for-dollar, you probably have more risk to markets returning
to fair value even though bonds are expensive to stocks.

On Wednesday, after an overnight session filled with updates, clarifications,
exceptions, and corrections to the so-called Greece deal, we will get to enjoy
the happy news about January Existing Home Sales (Consensus: 4.66mm from 4.61mm).
Since the weather in January was better-than-average, it is fair to expect
a strong number, which means the market ought to react more to any downside
surprise than to an upside surprise. But the magic number is 5 million. Existing
Home sales haven't been there, except for a brief spike in late 2009, since
2007. But prior to 2002, a pace of 5-5.5mm Existing Home Sales was a fairly
typical level (see Chart, source Bloomberg), and would imply that properties
are finally starting to clear at something like normal rates. The data may
be a little messy for a few months as bank REO property gets put back on the
market (potentially driving up both inventory and sales numbers), but 5mm is
the level to hope for.

Michael Ashton is Managing Principal at Enduring
Investments LLC, a specialty consulting and investment management boutique
that offers focused inflation-market expertise. He may be contacted through
that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist,
and salesman during a 20-year Wall Street career that included tours of duty
at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation
derivatives markets and is widely viewed as a premier subject matter expert
on inflation products and inflation trading. While at Barclays, he traded
the first interbank U.S. CPI swaps. He was primarily responsible for the creation
of the CPI Futures contract that the Chicago Mercantile Exchange listed in
February 2004 and was the lead market maker for that contract. Mr. Ashton
has written extensively about the use of inflation-indexed products for hedging
real exposures, including papers and book chapters on "Inflation and Commodities," "The
Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven
Investment For Individuals." He frequently speaks in front of professional
and retail audiences, both large and small. He runs the Inflation-Indexed
Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes
for client distribution and more recently for wider public dissemination.
Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University
in 1990 and was awarded his CFA charter in 2001.